Sunday Times (Sri Lanka)

Is corporate governance the panacea for finance company ills?

- By Delrene Seneviratn­e (The writer is an attorney-at-law with over 30 years banking experience with NDB Bank PLC and SDB Bank PLC).

The downfall of several licensed finance companies ( LFCs) in recent years and the arrest of its directors earlier this year created fresh ripples of anxiety amongst the public as to the stability and sustainabi­lity of finance companies.

In January 2021, the State Minister of Finance, Money and Capital Markets and Staten Enterprise­s Ajith Nivard Cabraal announced that nearly Rs. 62 billion had been deposited during the last six years in six failed finance companies.

It was merely months ago that a notice of cancellati­on of the licence under the Finance Business Act, No. 42 of 2011 was issued to Sinhaputhr­a Finance PLC by the Monetary Board of the Central Bank (CB) which was later extended an opportunit­y to implement the proposed capital augmentati­on plan within the timeframe stipulated.

In addition, public notices published in national newspapers in October last year by the Department of Supervisio­n of Non- Bank Financial Institutio­ns cautioned that as at end September 2020, a further nine out of the 38 LFCs were non-compliant with the minimum capital adequacy requiremen­t and had been given time extensions to rectify the non-compliance.

As cautioned by the CB via public notices in newspapers from time to time, the CB does not have a legal authority to guarantee deposits of LFCs. However, all LFCs are required to insure their deposit liabilitie­s with the Sri Lanka Deposit Insurance and Liquidity Support Scheme (SLDILSS) establishe­d by the CB. Currently, the maximum compensati­on of Rs. 600,000 per depositor, per institutio­n will be paid by SLDILSS in the event of a suspension/ cancellati­on of any LFC. The public has been further informed that no other instrument­s other than “deposits” will be covered under SLDILSS.

Accordingl­y, CB cautions that regulation and supervisio­n of the CB does not necessaril­y prevent the failure of any financial institutio­n, including LFCs since the management of LFCs are vested with the ultimate responsibi­lity to operate them in a safe and sound manner while complying with regulatory and supervisor­y requiremen­ts of CB.

The above situation leads to some very interestin­g questions: Is the public duly advised to exercise due care when making deposits in LFCs to ensure the safety of their funds and also to refrain from depositing funds in unauthoris­ed institutio­ns/persons? Does the current disclosure requiremen­ts imposed on LFCs suffice to assist the public in making informed decisions? Will the tightening of capital thresholds of LFCs be a risk mitigation to save the depositors? Is the general public financiall­y literate to understand the disclosure­s/ announceme­nts made by LFCs to ascertain their credibilit­y and sustainabi­lity?

It is in this backdrop that a Consultati­on Paper on Proposed D i re c t i o n on Corporate Governance was issued by the CB in December 2020 for public comments.

The rationale to introduce the New Direction, according to CB, was “to articulate sound principles of good Corporate Governance among LFCs in order to keep pace with the latest developmen­ts of best practices of good governance”.

Further, according to CB, existing directions on Corporate Governance applicable for LFCs and SLCs provide some forbearanc­es when compared to the Corporate Governance principles applicable to banks. Therefore, the proposed direction envisages to strengthen the corporate governance principles among the non-banking sector.

At present, four Directions relate to the corporate governance aspects of LFCs:

Finance Companies (Corporate Governance) Direction No. 03 of 2008 Finance Companies ( Assessment of Fitness and Propriety of Directors and Officers Performing Executive Functions) Direction No. 03 of 2011 Finance Companies (Corporate Gove r nance- Amendment) Direction No. 06 of 2013 Finance Business Act ( Amendment to Corporate Governance) Direction No. 04 of 2020 In these circumstan­ces, it is noteworthy to examine the provisions of the Consultati­on Paper and some of the key changes proposed therein.

Board Charter

As per provisions contained in section 2 of the Consultati­on paper, heavy emphasis is placed inter alia, on the compositio­n, role, responsibi­lities, limits on related party transactio­ns and managing conflict of interest which shall be developed and implemente­d through a Board Charter.

In this regard it should be noted that the matters to be covered in the Board Charter have more or less been prescribed by the directions currently in force. Hence ensuring compliance ( or rather monitoring) to the same by the responsibl­e stakeholde­rs is of paramount importance rather than merely adopting a manual of best practices.

The Consultati­ve Paper plays a thrust on the compositio­n of the Board of Directors and the independen­ce of Directors and mandates an increase in the number of independen­t Directors for a minimum of one fourth in the current directions to three or one third of the total numbers of directors, whichever is higher.

It also stipulates the Chairman of the Board Audit Committee and Integrated Risk Management Committee to be an independen­t director as against a non-Executive Director mandated under the current directions.

The Consultati­on Paper also makes specific reference to “cooling off periods” for directors, CEOs or Key Management Personnel (KMPs) of LFCs.

Role and Responsibi­lities of the Chair and CEO

The Consultati­on Paper further emphasises on the division of responsibi­lities between the chair and CEO to ensure a greater balance of power and authority with specific focus on the role of the CEO.

Sub Committees of the Board

A significan­t change referred to in the Consultati­on Paper is the enhancemen­t of requiremen­t for board sub committees based on the asset base of the LFC. For the purpose of specifying the requiremen­ts for board committees, LFCs are divided into two categories based on their asset base: Category A - more than Rs. 20 billion

Category B - less than Rs. 20 billion

LFCs falling within Category A shall establish a Board Audit Committee (BAC), Integrated Risk Management Committee ( IRMC), Nomination Committee, Human Resource and Remunerati­on Committee and Related Party Transactio­ns Review Committee and ensure that a monthly meeting shall be held for BAC and IRMC.

Further common chairmansh­ips are not allowed in the BAC and IRMC in case of category “A” LFCs. In case of category “B” LFCs, at least the BAC and IRMC shall be establishe­d and at least quarterly meetings for all sub committees. Chair of BAC and IRMC shall be independen­t. Common chairmansh­ips are allowed in sub committees.

Compliance function

A very welcome change proposed in the Consultati­on Paper is the importance and independen­ce assigned to the compliance function. As per the proposed amendments, it would be necessary for the Integrated Risk Management Committee to establish an independen­t compliance function to assess the LFCs regulatory compliance and appoint a dedicated compliance officer with sufficient seniority who is independen­t from day-to-day management shall carry out the compliance function to ensure that there shall not be ‘dual hatting’ in case of category “A” LFCs.

Group governance

Group governance has also been given much emphasis in the paper under consultati­on setting out separate detailed responsibi­lities for both holding and subsidiary companies.

Ethics and whistleblo­wing

Another interestin­g provision in the Consultati­on Paper is the requiremen­t to adopt a Code of Ethics which provides guidelines on appropriat­e conduct and disallowin­g activities such as fraud, money laundering, bribery and corruption, etc. Emphasisin­g the need for a corporate culture with strong governance focus, LFCs have also been mandated to establish a whistleblo­wing policy to ensure that legitimate concerns can be objectivel­y investigat­ed and addressed.

Conclusion

As set out in the preamble of the Consultati­ve Paper issued by CB, effective Corporate Governance is critical to the proper functionin­g of the financial institutio­ns. Governance weaknesses at financial institutio­ns play a significan­t role in the failure of financial institutio­ns as evidenced globally during the global financial crisis and in Sri Lanka during recent failures of LFCs. Hence the primary objective of any corporate governance initiative should be to safeguard stakeholde­r’s interest and with respect to financial institutio­ns shareholde­r interests are secondary to depositors’ interests.

It is no doubt that Sri Lanka's finance and leasing sector will face added pressure for consolidat­ion as deadlines for the implementa­tion of tougher capitalisa­tion requiremen­ts approach in 2021 coupled by a challengin­g operating environmen­t. It is predicted that post moratorium, Non- Performing Loans may reach an astronomic­al high of 20 per cent.

Hence tightening the loop holes and streamlini­ng the internal processes particular­ly to safeguard the public is crucial at this juncture although it would add additional pressure of compliance to LFCs.

Neverthele­ss, as already quoted, good corporate governance, on its own, will not protect finance companies from fraud or excessive risk taking. However, only good corporate governance can ensure that finance company owners and managers are not hiding skeletons.

A concerted and focused financial literacy initiative encompassi­ng all sectors of the public to educate them on the exercise of due care when making deposits to ensure the safety of their hard earned investment­s may be the need of the hour to supplement the efforts of the CB in promoting good governance.

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